In early December 2012, Treasury
published final regulations (T.D. 9604)
and additional interim guidance under Sec.
4191 relating to the medical device excise
tax that was enacted as part of the Health
Care and Education Reconciliation Act of 2010, P.L. 111-152, in
conjunction with the Patient Protection
and Affordable Care Act, P.L. 111-148 (the
health care acts).

Effective Jan. 1, 2013, Sec. 4191 imposes
a 2.3% excise tax on sales of certain
medical devices by the devices’
manufacturer, producer, or
importer. The regulations generally adopt
the guidance in the proposed regulations
issued on Feb. 7, 2012 (REG-113770-10), but
provide greater certainty with respect to
the types of devices subject to the medical
device excise tax and clarify the retail and
other exemptions.

The IRS and Treasury continue to
evaluate certain issues and issued Notice 2012-77and a frequently asked questions document (available at tinyurl.com/cchfbez) with interim guidance on some
of the more significant issues facing the
medical device industry as it readied itself
for and implemented the medical device
excise tax. In particular, Notice 2012-77
provides guidance on:

Determining the taxable sale price for
certain common supply chain scenarios
under the constructive pricing rules;

Treatment of licensed
software;

Donations of
taxable medical devices;

Excise tax treatment of FDA-listed
medical device kits; and

Interim penalty relief to taxpayers
for the first three calendar quarters of
2013.

Observation:Although the regulations and
interim guidance provide clarity on the
medical device excise tax, organizations
will continue to face challenges in
complying with this law.

Transition Rule Provided

The regulations provide transition relief
for certain long-term contracts, including
leases and installment sales. Specifically,
payments made on or after Jan. 1, 2013, for
contracts entered into before March 30,
2010, are not subject to the medical device
excise tax unless the contract was
materially modified on or after March 30,
2010, the date the health care acts were
enacted.

Taxable Medical
Devices

Under the statute, a “taxable
medical device” is any device, as defined
under Section 201(h) of the Federal Food,
Drug, and Cosmetic Act, P.L. 75-717 (FFDCA),
that is intended for humans. The regulations
narrow the scope of this definition to
products (with certain exemptions and
exclusions) listed with the U.S. Food and
Drug Administration (FDA) under Section
510(j) of the FFDCA and 21 C.F.R. Part 807,
or that the FDA determines should have been
so listed. They also clarify that certain
biologic devices, such as those used for in
vitroblood screening that are regulated
under 21 C.F.R. Part 607 and not listed with
the FDA under Section 510(j) of the FFDCA
and 21 C.F.R. Part 807 do not meet the
definition of a taxable medical device.

Observation:Taxpayers that manufacture,
produce, or import listed medical devices
that may be sold either as medical devices
or for other uses (e.g., a microscope) are
nevertheless taxed on all sales of such
devices unless another exemption or
exclusion applies. This includes FDA-listed
devices sold for veterinary use. Similarly,
FDA-listed medical devices that are combined
with branded prescription drugs are not
exempt from the medical device excise tax,
even if the same article is subject to the
branded prescription drug fee imposed by the
health care acts.

Manufacturer, Producer, or
Importer

Existing regulations broadly
define the term “manufacturer” to include
“any person who produces a taxable article
from scrap, salvage, or junk material, or
from new or raw material, by processing,
manipulating, or changing the form of an
article or by combining or assembling two or
more articles. The term also includes a
‘producer’ and an ‘importer’” (Regs. Sec.
48.0-2(a)(4)(i)). Note that definitions of
“manufacturing” or “production” used by the
FDA or in the Internal Revenue Code under
subpart F (Secs. 951–965) or Sec. 199 do not
apply to the excise tax.

Taxable use: Taxable
uses of medical devices by the manufacturer,
producer, or importer (MPI) are subject to
the manufacturers excise tax rules of Sec.
4218.

Donated Medical
Devices

Donated medical devices are
not specifically addressed in the
regulations; however, under the interim
guidance, a donation of a taxable medical
device to an eligible charitable
organization is not treated as a taxable
use, provided the device is not intended to
be sold by the donee. For this purpose, an
eligible charitable organization is defined
by Sec. 170(c) and generally includes U.S.
federal, state, and local governments and
U.S. charities organized and operated
exclusively for religious, charitable,
scientific, literary, or educational
purposes, or to foster amateur athletic
competition.

Products
Used for Demonstration, Promotion, or
Testing

The regulations’ preamble
indicates that FDA-listed medical devices
used for demonstration purposes (e.g.,
displayed at a medical device trade show)
are likely taxable when first used (citing
Rev. Ruls. 60-290 and 72-563). The
subsequent sale of the used device is not
taxable, however. FDA-listed medical devices
that are provided as samples likely have a
similar treatment. If an FDA-listed medical
device is used by its manufacturer to test
another device that it also manufacturers,
the first device is not subject to tax on
such use; but providing devices for testing
or evaluation by others likely is
considered a taxable use
under Sec. 4218 and the regulations. The tax
is computed based on the price for which the
product would have otherwise sold.

Exemptions

Secs. 4221 and
4191 provide general exemptions to the tax
that include (1) products exported or
destined for export; (2) components sold for
further manufacture; (3) products intended
for nonhuman use; and (4) eyeglasses,
contact lenses, hearing aids, or any other
medical device the IRS determines to be “of
a type which is generally purchased by the
general public at retail for individual use”
(the retail exemption).

Retail exemption: The
regulations retain the
facts-and-circumstances approach in the
proposed regulations to determine whether an
otherwise taxable medical device is
generally purchased by the public at retail
for individual use and thus qualifies for
the retail exemption. The regulations
emphasize that this approach requires a
balancing of factors in which no one factor
is determinative.

The proposed
regulations included a nonexclusive list of
positive and negative factors, as well as a
list of safe-harbor factors, for determining
whether the retail exemption applies. The
final regulations adopt and expand on these
factors, particularly criteria for whether
consumers who are not medical professionals
can purchase a device. The regulations also
provide examples of how to evaluate all
three sets of factors.

Positivefactors (Regs. Sec.
48.4191-2(b)(2)(i)) include:

Consumers who are not medical
professionals can purchase the device
directly through sales channels including
in person, over the telephone, or over the
internet; through retail businesses such
as drugstores, supermarkets, or medical
supply stores; and through retailers that
primarily sell devices (e.g., specialty
medical stores; sellers of durable medical
equipment, prosthetics, orthotics, and
supplies (DMEPOS); and similar vendors);

Consumers who are not medical
professionals can use the device safely
and effectively for its intended medical
purpose with minimal or no training from a
medical professional; or

The
device is classified by the FDA under
subpart D of 21 C.F.R. Part 890 (physical
medical devices).

Negativefactors (Regs.
Sec. 48.4191-2(b)(2)(ii)) to be considered
in applying the retail exemption
include:

The device must
generally be implanted, inserted,
operated, or otherwise administered by a
medical professional;

The
cost to acquire, maintain, and/or use the
device requires a large initial investment
and/or ongoing expenditure that is not
affordable for the average consumer;

The device is a Class III device under
the FDA system of classification;

The device is classified by the FDA
under any of a number of categories,
including cardiovascular, general and
plastic surgery, and dental; or

The device qualifies as DMEPOS for
which payment is available exclusively on
a rental basis under Medicare Part B
payment rules and is an “item requiring
frequent and substantial servicing” as
defined in 42 C.F.R. Section 414.222.

The regulations include 15
examples that illustrate the retail
exemption, including safe-harbor provisions
described below, and balancing factors for
particular devices. Two of these examples
are of products in classification categories
21 C.F.R. Parts 868 (anesthesiology devices)
and 876 (gastroenterology-urology
devices), as well as examples of home
health care products (oxygen concentrators,
wheelchairs, and therapeutic beds).

Observation:The totality of the facts and
circumstances relating to a listed medical
device determines whether it qualifies for
the retail exemption. Single factors may be
more meaningful than others, but no one
factor is determinative. All relevant facts
and circumstances must be considered,
including those not listed in the
regulations.

Safe
Harbor

The regulations maintain the
proposed regulations’ safe harbor for
certain devices under the retail exemption,
including FDA-approved in vitrodiagnostic home-use lab tests,
devices designated or classified by the FDA
as available over the counter, and certain
DMEPOS. The regulations and preamble also
clarify that prosthetic and orthotic
devices, as defined in 42 C.F.R. Section
414.202, meet the retail exemption if they
do not require implantation or insertion by
a medical professional (even if they require
initial or periodic fitting or
adjustment).

Devices that do not
qualify for safe-harbor treatment may still
qualify for the retail exemption based on
all the facts and circumstances.

Medical Devices Not Intended
for Humans

The regulations adopt the
guidance in the proposed regulations on the
“intended for humans” element of the
definition of a taxable medical device. The
preamble to the proposed regulations
explains that veterinary devices, while
included in Section 201(h) of the FFDCA, are
not taxable medical devices if they are
intended for use exclusively in veterinary
medicine and labeled as such. Devices used
exclusively for certain other nonmedical
purposes, such as “research use only”
devices or those subject to an
“investigational device exemption” from FDA
approval, are not taxable if they are listed
with the FDA as such.

Determination of
Taxable Price

The medical device
excise tax was enacted as a manufacturer’s
excise tax under Internal Revenue Code
chapter 32, and the IRS and Treasury
intended to rely on the existing body of
statutes, regulations, and
interpretations in administering the new
tax. For example, manufacturers excise taxes
are levied on an MPI’s sale to an unrelated
“wholesale distributor,” as defined under
Regs. Sec. 48.4216(b)-1(c)(3), with certain
adjustments. Sec. 4216(b) and the
regulations thereunder contain rules for
transactions that do not fit this model;
these are known as the “constructive sale
price” (CSP) rules. However, the IRS and
Treasury have received numerous comment
letters and informal communications
illustrating situations where the CSP rules,
applied to manufacturers of medical devices,
lead to an inequitable result. The IRS has
provided interim guidance in Notice 2012-77
as it continues to study these issues.

One of the challenges in applying the
existing CSP rules to the medical device
industry is that key
participants in medical device supply
chains do not easily conform to the
definitions in the existing CSP rules. For
example, the definition of a wholesale
distributor in Regs. Sec. 48.4216(b)-1(c)(3)
is “a person engaged in the business of
selling articles to persons engaged in the
business of reselling such articles.” In
many cases, medical device manufacturers
sell their products to distributors who may
sell the products to hospitals, clinics, and
physicians. However, since these customers
frequently consume the products in the
delivery of various health care services,
the distributors do not meet the definition
of wholesale distributors. Indeed, the IRS
states in Section 4 of Notice 2012-77 that,
until it provides further guidance, sales to
hospitals and doctor’s offices are treated
as retail sales (i.e., sales to end
users).

CSP Rules for
Different Supply Chains

Notice
2012-77 addresses many of the common supply
chain scenarios in the medical device
industry and provides a CSP for each. In
lieu of using the actual sale price of an
article or determining its fair market price
(for which the taxpayer bears the burden of
proof), under interim rules, taxpayers may
apply a CSP illustrated in Notice
2012-77.

For
direct sales by the MPI to unrelated end
users at retail; no regular sales to
independent wholesale distributors: The CSP is 75% of the actual selling
price after certain adjustments (e.g.,
the medical device excise tax, freight,
and insurance) and certain readjustments
(e.g., rebates).

Sales to
unrelated retailers; no regular sales to
independent wholesale distributors: The CSP is 90% of the lowest price
sold to unrelated retailers, less the
medical device excise tax. No other
adjustments or readjustments are
available.

Sales to
related retailers; no regular sales to
independent wholesale distributors: The CSP is 71.25% of the actual
selling price (to an unrelated person),
less the medical device excise tax. The
CSP is lowered from 75% to make up for
exclusions otherwise allowed in Sec.
4216(a). No other adjustments are
allowable, but price readjustments
appear to be available.

Sales to
related reseller that leases and sells
at retail: The
CSP is 71.25% of the actual selling
price (to an unrelated person). As in
(3), the CSP is lowered from 75% to make
up for exclusions otherwise allowed in
Sec. 4216(a). No other adjustments are
allowable, but price readjustments
appear to be available.

Sales to
related reseller that only leases at
retail; no regular sales to independent
wholesale distributors: The price is the actual sale price
to the related reseller, provided that
the selling price reasonably
approximates the fair market price of
the article under Sec. 4216.

Use ofTransfer Pricing

The preamble
to the regulations states that the standards
for manufacturers excise taxes under Sec.
4216 are different from those for
determining arm’s-length prices for income
tax purposes under Sec. 482. Therefore,
while some facts used to support a transfer
price for purposes of Sec. 482 may be
relevant for determining medical device
excise tax, transfer-pricing studies
generally are not conclusive for the excise
tax.

Observation:It appears that the IRS is
skeptical that companies can successfully
present economic analysis and expert
testimony that will meet the burden of proof
in establishing a fair market price in cases
where the taxable transaction involves a
related party. Although the interim guidance
does provide helpful relief in certain
supply chain scenarios, some companies may
believe that using an appropriately
determined arm’s-length price other than the
unrelated price, the CSP, or the Notice
2012-77 CSP will prevent overpaying the
medical device excise tax.

The
regulations also reiterate the existing
rules regarding rebates and other price
readjustments; these items may be taken into
account only when they occur and cannot be
accrued.

Observation:Note that neither the
regulations nor Notice 2012-77 provided any
specific guidance on two issues that are
significant to the industry: the medical
device excise tax treatment of (1) fees paid
to group purchasing organizations; and (2)
instrumentation provided at no charge to
hospitals, medical institutions, doctors,
and others.

Replacement
Parts and Refurbishing Used Devices

The regulations’ preamble clarifies that
replacement parts are subject to the medical
device excise tax if they are separately
listed medical devices, as they meet the
definition of a taxable medical device. If
an article is replaced under warranty, the
taxable price of the replacement article is
the amount paid, if any, to the
manufacturer.

The preamble also states
that if the refurbishing or remanufacturing
activity creates a new and different listed
medical device, then the activity
constitutes manufacturing, and the resulting
device is taxable upon its sale or use. The
regulations adopt the positions contained in
prior rulings regarding what type and level
of activity constitutes manufacturing a new
article.

Licenses and
Leases

The regulations adopt a
provision of the proposed regulations that
addresses leases of medical devices
and refers to Sec. 4217(a),
which provides that the lease of a taxable
article by the manufacturer is
considered a sale. The tax can be applied to
leases in either of two ways. If the
manufacturer is also in the
business of selling devices in arm’s-length
transactions, the tax is
applied to each lease payment until the tax
equals 2.3% of the sale price of the device.
Otherwise, the tax is applied to each lease
payment, effectively causing the
manufacturer to pay tax on
the interest amount inherent in the lease
payments.

Notice 2012-77 also provided
in interim guidance that a license of
software that is an FDA-listed medical
device is treated as a lease of that device
as of the date both parties entered into the
license agreement.

Kits

In some cases,
taxpayers assemble, sterilize, and
vacuum-seal FDA-listed medical devices and
possibly other items to sell as a kit for
customers’ convenience. The FDA requires
many of these kits to be listed as medical
devices. Under the proposed regulations,
FDA-listed medical device kits were
considered taxable, and the listed medical
device components of a kit were
considered tax-free sales of
components for further manufacture.
The IRS and Treasury have issued interim
guidance as they continue to study this
issue; however, the final regulations do
provide that hospitals and other medical
institutions that assemble kits for their own use
are not producing taxable medical devices, because the FDA exempts such
“self-kitters” from its listing
requirements.

Observation:The interim guidance in Notice
2012-77 splits the medical device excise tax
treatment of kits into domestically produced
and imported kits. Kits produced
domestically are not taxed (although listed
medical device components they contain are
taxable), while sales by importers of
imported kits are taxed on the portion of
their price that is allocable to the
FDA-listed medical device components they
include. Importers that, in addition to
imported kits, sell all of the kits’
components separately may use the sale price
of the taxable components relative to the
kits’ sale price to determine the taxable
portion of the kits; importers that do not
also sell all the components individually
may use a relative cost allocation.

Compliance Requirements

The regulations’ preamble confirms that,
as with other excise taxes, medical
device excise tax deposits must be
made semimonthly unless the
expected liability for a calendar quarter is
$2,500 or less (in which case payments may
be made quarterly). The first medical device
excise tax deposit, covering the first 15
days of January, was due on Jan. 29, 2013.
The IRS is allowing transition relief from
deposit penalties during the first three
calendar quarters of 2013, provided that
taxpayers demonstrate a good-faith effort to
comply with the tax deposit rules and that
the failure was not due to willful neglect.
Taxpayers report their medical device excise
tax on Form 720, Quarterly
Federal Excise Tax Return, which is
filed within 30 days following each calendar
quarter.

In addition to paying the tax and
filing Form 720, if a company expects to
have tax-free sales, such as exports or
component sales for further manufacture,
then it must register with the IRS using
Form 637, Application
for Registration (for Certain Excise Tax Activities). The regulations’ preamble makes
clear that the Form 637 and Form 720
requirements apply on a legal-entity-level
basis (i.e., each entity with a separate
employer identification number, including
disregarded entities, is subject to these
compliance requirements).

Observations:In light of these upcoming
compliance deadlines, taxpayers should
develop a process for computing the tax,
including calculating and supporting price
adjustments such as discounts, rebates,
refunds, and allowances. Companies also need
to determine whether they are eligible for
any of the exemptions and be able to
document and support the claimed exemptions.
Companies may need to provide the IRS with
proof of further manufacture by
their customers and proof of exportation by
them or their customers.

Moreover,
complying with the medical device excise tax
may require information technology system
updates to handle frequent tax
computations and to track
purchases. New processes must also be
established to handle registration
requirements, exemptions, and
credit and refund issues.

Comment Period

The IRS
is requesting taxpayer comments on the
regulations and interim rules in Notice
2012-77. The deadline for comments on the
notice is March 29, 2013. In particular, the
IRS is requesting comments on:

Supply chains commonly employed by
the medical device industry.

How
the CSP rules might address medical device
industry segmentation, including what is a
reasonable percentage of the applicable
sale price for determining the CSP for a
segment or product.

Alternative
methods for determining price for the
supply chain scenario where a manufacturer
sells to related resellers that lease but
do not sell taxable medical devices at
retail and neither the manufacturer nor
the reseller sells regularly to
independent wholesale distributors.

Identification
of listed components of devices where the
devices are exempt under Sec. 4191(b) and
Regs. Sec. 48.4191-2(b) and the components
are not included in a safe harbor or do
not otherwise fall within the retail
exemption by application of the
facts-and-circumstances test.

The
authors thank Arianda Hicks, CMI, Houston;
Christine Kraft, CPA, J.D., Parsippany,
N.J.; and John Badertscher, CPA, Stamford,
Conn., for their contributions to this
item. A version of this item originally
appeared as a Deloitte Tax
Alert.

EditorNotes

Jon Almeras is a tax manager with
Deloitte Tax LLP in Washington, D.C.

For additional information about these
items, contact Mr. Almeras at 202-758-1437
or jalmeras@deloitte.com.

Unless
otherwise noted, contributors are members
of or associated with Deloitte Tax
LLP.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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